26 October 2016, 15:00
By Ira Iosebashvili
The dollar has its doubters.
The U.S. currency had surged 2.5% in October through Tuesday, on pace for its second-strongest monthly gain of the year, reflecting expectations that the Federal Reserve will raise interest rates in December. October's rise has put the WSJ Dollar Index within striking distance of breaking into positive territory for 2016 for the first time since February.
Yet several signs suggest that the U.S. currency won't rise much further for now. U.S. economic growth is slackening, many investors say, pointing to subpar recent readings in consumer confidence and inflation. The slowdown likely will limit the Fed's capacity to raise rates further next year as necessary for further currency appreciation, analysts say.
Some investors are warning that a nearly six-year dollar bull market is in its last stages. The currency has risen 36% against major rivals since 2011, but the latest gains have been driven almost exclusively by the declines of the British pound, euro and yen. By contrast, the dollar rose against all major currencies except for the Swiss franc last year, and it was the undisputed champion of the foreign exchange markets in 2014, according to Deutsche Bank data.
"After such a big move, you eventually need to wonder when the correction is going to come," said Thomas Flury, head of currency strategy at UBS Wealth Management, which oversees some $2 trillion world-wide. "This rally seems to be coming to an end."
A stalling dollar would have widespread implications. It could ease pressure on U.S. corporate earnings and therefore underpin further stock-market gains. It also could boost prices for oil and other commodities denominated in the U.S. currency, potentially supporting commodity-dependent emerging economies.
At the same time, a weaker dollar could spell trouble for central banks in Europe and Asia, which have fought to boost their economies by keeping their currencies cheap.
One potential warning signal is the U.S. current-account deficit, which has widened in the past two years as the dollar's strength makes U.S. products pricier abroad. The U.S. trade gap stood at 2.6% of gross domestic product in the second quarter, more than 18% higher than 2014. While that figure isn't high by the pre-financial crisis standards, sharp increases often have coincided with peaks in previous dollar bull markets.
"The data in the U.S. has been OK but not spectacular," said Daragh Maher, head of U.S. foreign-exchange strategy at HSBC Holdings PLC. "When you have data that is trundling along sideways, it makes sense that the dollar will go sideways as well."
The dollar is down 1.8% this year, after rising 8.6% in 2015 and 12.5% in 2014.
Many skeptics see parallels with February, when a dollar rise was short-circuited by a broad financial-market retreat that prompted central banks led by the Fed to take an easier stance on stimulus. The amount of money betting on a higher dollar last week climbed to its highest level since February, data from the Commodity Futures Trading Commission showed. That could open the door to a sharp reversal if sentiment changes.
Mr. Flury said he is advising clients to use the rally as an opportunity to take profits. He believes the euro will rise to $1.20 against the dollar in 12 months, from about $1.09 on Wednesday.
"We are skeptical about all of this," Mr. Flury said, regarding the dollar's recent gains.
Other investors remain sanguine. Central banks in Europe, Japan and China are keeping rates near record lows, making the U.S. an attractive destination for investors seeking yield.
Past dollar bull markets typically have turned when the currency has risen about 20% above its purchasing power parity, a broad measure of relative value, according to Deutsche Bank. Despite its big gains, the dollar has risen only 10% above its PPP.
"As long as the U.S. is climbing the interest-rate table rather than falling down, it has been consistent with a stronger dollar," said Alan Ruskin, global head of G-10 currency strategy at Deutsche Bank.
U.S. politics also may be an important factor in determining the dollar's direction, said David Woo, head of global rates and currencies research at Bank of America Merrill Lynch. Fiscal spending in the U.S. likely would boost the economy and lift the dollar, Mr. Woo said.
Most fiscal-policy analysts, however, say major new stimulus is likely only if one party controls Congress and the White House. For now, many forecasters see divided government as the most likely outcome of the Nov. 8 election, with Hillary Clinton winning the presidency while the GOP, with a smaller and more conservative majority, holding on to at least the House of Representatives.
The dollar likely would fall roughly 10% against the euro and yen in a gridlock scenario, Mr. Woo said. Together, the two currencies account for more than 50% of the WSJ Dollar Index.
"I cannot remember a time in recent memory that politics were so important to the dollar," he said.
Write to Ira Iosebashvili at ira.iosebashvili@wsj.com
